Understanding the Expense Deduction Changes in Real Estate

Understanding the Expense Deduction Changes in Real Estate

1.3.19

By Shawn Filipowicz, CPA | Manager, Tax

Effective January 1, 2018, your interest expense deduction may be limited. But why would any administration want to hinder that process? After all, taking out a loan to start a business, or help grow your existing business, is crucial for anyone chasing the “American dream”. To help mitigate the outrage amongst taxpayers, legislators wrote in some exceptions to ease the pain. These exceptions are geared towards three types of taxpayers: small business, farming, and real estate. This article focuses on the impact on the real estate industry.

Under the small business exception, taxpayers that qualify under code section 448(c), with average annual gross receipts under $25 million are exempt from the new tax legislation.

Determining if you qualify for the small business deduction if you are within the real estate industry

First, related businesses must be aggregated to calculate the $25 million thresholds. These rules are complicated but have been a part of the Internal Revenue Code for years. We won’t get into the boring code language here, but if businesses share common ownership (more than 50%) or share services (one entity regularly performs functions for the other, and they have a common owner), you must include both businesses’ revenues in testing the $25 million thresholds.

Secondly, businesses deemed “tax shelters” are not eligible for the small business exception regardless of their annual revenues. In the real estate industry, we often refer to these as “syndicates”. This is a business (other than C Corporation) where more than 35% of the losses are allocated to “limited partners or limited entrepreneurs”. The definition is a bit vague in the code, but by considering similar definitions within the legislation, we deduce that these are dependent on participation. Meaning, an owner who does not actively participate in the management of the business, will be considered limited.

As we can see, many entrepreneurs investing in real estate could be precluded from using the small business exception. In that case, they can look to the real property trade or business election. “Real property trade or business” means real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business can make this election and continue to deduct their interest expense. However, and it’s a big however, businesses making this election are required to use alternative depreciation system (ADS) depreciation on any nonresidential rental property, residential rental property, and qualified improvement property.

There is much consideration that needs to be given before making this election. If you have questions regarding these new regulations, reach out today to discuss your specific situation.